Accountants learn early on that there are multiple types of accounts classified as assets, liabilities, equity, revenues or expenses. This is considered fundamental knowledge in accounting. What’s a little less widely known are the temporary accounts.
In practice, accountants use temporary accounts to record transactions. The purpose of this article is to define temporary accounts, provide examples and explain the different types of temporary accounts.
What are Temporary Accounts in Accounting? (The Definition)
An important concept in accounting standards is the separation of financial periods. This means that recording a transaction in the period in which they occurred is paramount. Being able to show activities for different financial periods is crucial too.
To do this in practice, there are temporary accounts (also known as nominal accounts). More specifically, temporary accounts keep the record of transactions for a financial period.
These accounts start every financial period with a balance of zero and all transactions recorded during the period will be closed out and transferred to another account (usually a permanent account) at the end of the financial period.
That way, the temporary account can start fresh at the beginning of every financial period which allows for easier tracking of financial activity for a specific period.
The main purpose of temporary accounts is to make sure activities from different periods are not mixed together which would be an overstatement of profits. Due to the nature of these accounts, they are considered as short-term accounts.
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Examples of Temporary Accounts in Accounting
Let’s take the example of Carl’s Construction Company (“CCC”). The financial year of CCC is 31 December of each year.
For the year ended 31 December 2022, CCC recorded sales of $120,000 in the revenue account, $60,000 in the cost of goods sold account and $20,000 in the administrative expense account.
From 1 January 2023 to 31 March 2023, CCC recorded sales of $40,000 in the revenue account, $20,000 in the cost of goods sold account and $5,000 in the administrative expense account.
The accountant is preparing the performance report for the period from 1 January 2023 to 31 March 2023 to see profit for the first quarter of the year.
Surprisingly, the report shows revenues of $160,000, cost of goods sold of $80,000 and administrative expenses of $25,000 for net profit of $55,000. The accountant knows there’s something wrong with these numbers since they are abnormally high.
This is because the accountant has forgotten to close the 3 temporary accounts (revenues, cost of goods sold and administrative expenses) at the end of the financial year 31 December 2022.
Since these temporary accounts were not closed, all of their balances accumulated over the 2022 financial year got carried over to the financial year 2023. The report generated actually shows all transactions from 1 January 2022 to 31 March 2023.
To correct this situation, all 3 temporary accounts need to be closed on 31 December 2022 with their balances transferred to a permanent account.
This way, all 3 accounts start the new financial year with a zero balance on 1 January 2023 and will have only 2023 transactions recorded, avoiding overstatement of profits.
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The Different Temporary Accounts
Accounts that are part of the income statement are considered to be temporary accounts since they need to be closed out at the end of the financial year and start the new financial year with a zero balance.
These accounts can be split into three categories; the revenue accounts, the expense accounts and the income summary accounts.
Revenue Accounts
Revenue accounts are any accounts used to record sale transactions or any other types of income for a company, such as dividend income, interest income or gains on sale of assets just to name a few.
Since revenue accounts are natural credit accounts, in order to close a revenue account at the end of a financial year, a debit entry needs to be created with the balance of the revenue accounts. The other side of the entry (credit) goes to the income summary account.
| Debit | Credit | |
| Revenue accounts | $10,000 | |
| Income summary account | $10,000 |
Expense Accounts
Expense accounts are used to record expenses of the company. That can be the cost of goods sold or any other business expenses needed to run a company. For example, salaries, rent expenses, administrative expenses and so much more.
Expense accounts are natural debit accounts. This means in order to close an expense account at the end of a financial year, a credit entry needs to be generated with the balance of the expenses. The other side of the entry (debit) goes to the income summary account.
| Debit | Credit | |
| Income summary account | $5,000 | |
| Expense accounts | $5,000 |
The Income Summary Account
The income summary account is the balancing account. At the end of a financial period, all transactions from the revenue accounts and expense accounts are transferred to the income summary account as shown above.
By doing so, the income summary account displays the net results of the company for a financial period.
To close the income summary account, the balance in the account needs to be transferred to a capital account (generally the retained earnings).
- If the income summary account is at profit, the entry needs to debit the income summary account and credit the capital account.
- If the income summary account is at loss, the entry needs to credit the income summary account and debit the capital account.
| Debit | Credit | |
| Income summary account (from expense accounts) | $5,000 | |
| Income summary account (from revenue accounts) | $10,000 |
Net income summary account: Profit $5,000
| Debit | Credit | |
| Income summary account – net profit | $5,000 | |
| Retained earnings | $5,000 |
Recapping Learning About Temporary Accounts in Accounting
- Temporary accounts are income statement accounts, such as revenue accounts, expense accounts and income summary accounts.
- Temporary accounts should have a zero balance at the beginning of a new financial year in order to allow the accounts to only capture transactions of the new period.
- At the end of a financial period, temporary accounts should be closed out and the balance moved to a permanent account.
Temporary Accounts in Accounting: Final Thoughts
Temporary accounts are important for any accountant or business owner. They allow for transactions to be reflected correctly in the right financial period as long as they are accurately closed out at the end of every financial period.
Ensuring temporary accounts start a new financial year with a zero balance should become second nature. Doing so allows for accurate tracking of the performance of a company.
